Employer Stock Issues In Qualified Plans
Gregory K. Brown
ESOPs give employees an equity stake in the
company and provide an attractive finance
alternative.
Gregory K. Brown
is a partner with Katten Muchin Rosenman LLP,
in Chicago. His practice emphasizes Employee
Stock Ownership Plans (ESOPs), ERISA fiduciary
matters, tax-qualified retirement plans, executive compensation and ERISA litigation. Mr.
Brown has written extensively and given many
speeches and presentations on employee
benefits law topics across the country. He is a
leading authority on ESOPs and other forms of
employee ownership for both domestic and international employers. He is a past member of
the Board of Directors of The ESOP Association
and is a past chair of its Legislative and Regulatory Advisory Committee. Mr. Brown is currently the chair emeritus of the ESOP subcommittee of the American Bar Association’s Section of
Taxation Employee Benefits Committee. He is a
co-author of Tax Portfolio on Employee Stock
Ownership Plans (ESOPs), published by the Bureau of National Affairs. He can be reached at
[email protected].
An employee stock ownership plan
(ESOP) is a qualified defined contribution retirement
plan, much like a profit-sharing or 401(k) plan. An ESOP,
however, is designed to invest primarily in employer securities. The Employee Retirement Income Security Act of
1974 (ERISA) and the Internal Revenue Code of 1986
(Code), provide substantial tax incentives and planning
opportunities for employers that sponsor ESOPs. Besides
providing retirement benefits, ESOPs can address corporate finance and other business objectives, including
resolving ownership succession issues; diversifying investments; planning their estates and charitable donations;
borrowing funds to finance transactions or refinance debt;
reducing or eliminating federal income tax; and increasing employee benefits and productivity incentives. ESOPs
are attractive to employers for many reasons, but they
have special characteristics and requirements that distinguish them from other defined contribution plans.
ESOP AS DEFINED CONTRIBUTION PLAN •
The Code divides all qualified deferred compensation
plans into two categories — defined contribution plans
(Code §414(i); ERISA §3(34)) and defined benefit plans
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(Code §414(j); Treas. Reg. §1.401‑1(b)). A defined
contribution plan provides benefits equal to a participant’s account balance, which may include employer contributions, participant contributions, forfeitures, and a participant’s pro rata share of the
income, loss, and expenses applicable to the trust.
A defined benefit plan provides annuity benefits
on a formula, typically based on service and compensation.
An ESOP is another type of defined contribution retirement plan, which contains a stock bonus
plan element. A stock bonus plan is a plan established and maintained to provide benefits similar to
those provided by profit‑sharing plans, but distributable in employer stock. Treas. Reg. §1.401‑1(a)(2)
(iii) and (b)(1)(iii). ESOPs are subject to the same
general qualification requirements as profit-sharing
and other defined contribution plans, but there are
several special rules that distinguish them.
SPECIAL ESOP QUALIFICATION RE­
QUIRE­MENTS • An ESOP must be identified in
the plan document as an employee stock ownership
plan Treas. Reg. §54.4975-11(a)(2), and designed to
invest primarily in employer securities, Treas. Reg.
§54.4975-11(b). The Internal Revenue Service (IRS)
has not interpreted the phrase “designed to invest
primarily in employer securities,” but the phrase implies that an ESOP must be intended to permit the
plan trustees to invest or hold most of the plan assets in employer securities without specific duration
or percentage requirements. Similarly, Department
of Labor (DOL) guidance does not establish a specific standard for the “primarily invested” requirement, but instead looks to facts and circumstances.
DOL Advisory Opinion 83‑6A (Jan. 24, 1983). In
Advisory Opinion 83-6A, DOL stated that neither
ERISA nor the regulations impose a maximum or
minimum percentage on the amount of plan assets
that must be invested in employer securities under
ERISA §407(d)(6). Code section 409(l) defines “employer securities” as common stock issued by an
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employer that is readily tradable on an established
securities market. If an employer’s common stock
is not publicly traded, the term means common
stock issued by the employer that has a combination of voting powers and dividend rights equal to
or greater than the powers and rights of the class of
common stock of the employer that has the greatest
voting powers and the class of common stock that
has the greatest dividend rights. “Employer securities” also include non-callable preferred stock if
such stock is convertible into the qualified common
stock described above at a reasonable conversion
price (as of the date of acquisition by the ESOP).
Code §409(l)(3). For a discussion of employer security design, see Kim Schultz Abello and Gregory
K. Brown, ESOPs and Security Design: Common Stock,
Super Common or Convertible Preferred? 23 J. Pens. Plan.
& Compliance 99 (Summer 1997). The term “employer securities” also includes, for a non-publicly
traded company, securities issued by any member
of the employer’s controlled group of corporations.
Under Code section 409(l)(4), the phrase “controlled group of corporations” has the meaning
set forth in Code section1563(a) (disregarding subsections (a)(4) and (e)(3)(C)), except that the parent
company must own only 50 percent (rather than 80
percent) of the stock of a subsidiary for that subsidiary and those below it to be members of the
controlled group.
Code §415 Limitations for ESOPs
Code §415(c)(1) generally provides that the contributions that may be credited as “annual additions” to a participant’s defined contribution plan
accounts in a limitation year may not exceed the
lesser of (i) $49,000 (for 2011), or (ii) 100 percent
of the participant’s compensation. “Annual additions” are employer contributions, employee contributions, and forfeitures for the year to all defined
contribution plans sponsored by an employer. Code
§415(c)(6) contains a special limitation rule for leveraged ESOPs sponsored by C corporations. Un-
Qualified Plans | 31
der this special rule, if no more than one‑third of
the employer ESOP contributions are allocated to
highly compensated employees (as defined in Code
§414(q)), the employer contributions to the ESOP
that are used to pay interest on the ESOP loan
and reallocated forfeitures of employer securities
that were acquired with the proceeds of the loan
are excluded from the annual addition limitation
calculation.
The IRS final regulations issued in April 2007
provide that annual additions under an ESOP for
purposes of the Code §415 limits may be calculated
based on employer contributions used to repay an
exempt loan or based on the fair market value of
the employer securities allocated to participant accounts. See 72 Fed. Reg. 16,878 (Apr. .If the annual
additions are calculated based on employer contributions, appreciation in the value of the employer
securities from the time they were purchased and
placed in the suspense account is not counted for
Code §415 purposes. Treas. Reg. §54.4975-11(a)(8)
(ii).Dividends paid on employer securities held by
an ESOP generally are treated as plan earnings and
do not count against the Code §415 annual addition limits. See, e.g., Treas. Reg. §1.415(c)-1(b)(1)(iv).
Dividends
Unlike other defined contribution plans,
ESOPs may make tax-advantaged distributions of
dividends paid on employer securities. A C corporation may deduct dividends paid on employer securities held by a leveraged ESOP maintained by
the corporation or a controlled group member, provided that the dividends are paid in cash directly or
through the ESOP to ESOP participants or their
beneficiaries; reinvested in employer securities, if
participants have been given the election to receive
the dividends in cash or to reinvest them in employer securities; or used to repay an ESOP loan. Code
§404(k). The IRS has published proposed regulations that would deny a deduction to a U.S. subsidiary of a foreign parent for dividend payments
made by the parent. Prop. Treas. Reg. §1.404(k)-2.
In addition, the IRS has the authority to disallow
a dividend deduction that constitutes an avoidance
or evasion of taxation. Code §404(k)(5)(A). The special dividend distribution rules are not available to S
corporations. Any S corporation distributions that
are passed through an ESOP in a manner similar
to C corporation dividends will be treated as distributions from the plan. The 10 percent penalty tax
on early distributions will apply, withholding will be
required, participants whose account balances exceed $5,000 must consent in writing to receive the
distribution, and the distribution will be eligible for
rollover to an IRA or a qualified plan. Corporate
law “dividends” in an S corporation may not be
treated as “dividends” for tax purposes because a
“dividend” for tax purposes must be paid from current or accumulated earnings and profits, which an
S corporation does not have (unless it carries over
accumulated earnings and profits from a prior status as a C corporation). Code §§316 and 1371(c).
Dividends Paid To Participants
Dividends paid to ESOP participants or their
beneficiaries are deductible if they are paid in cash
directly or paid to the ESOP with a subsequent distribution to participants or beneficiaries within 90
days after the end of the plan year in which the
dividends are paid. Code §404(k)(2)(A)(i) and (ii).
The corporation paying the dividends is entitled to
take a deduction in the year in which the ESOP
participants or beneficiaries have a corresponding
income inclusion. Code §404(k)(4)(A). Code section 404(k) dividends paid in cash to ESOP participants and beneficiaries constitute ordinary income
to the participants and beneficiaries, and they are
exempt from the 10 percent penalty tax on early
distributions from qualified plans. Code §72(t)(2)
(A)(vi).They are not eligible for the 15 percent tax
rate on qualified dividends. Jobs and Growth Tax
Relief Reconciliation Act of 2003, Pub. L. No.
108-27, Code §1(h)(11)(B)(ii)(III).Tax withholding
32 | The Practical Tax Lawyer
is not required with respect to such dividend payments Code §3405(e)(1)(B)(iv) and the payments are
exempt from the $5,000 mandatory distribution restrictions. Code §411(a)(11)(C). However, they are
not eligible for tax-free rollover to an IRA or another qualified plan. Treas. Reg. §1.402(c)-2, Q&A4(e).
Dividends Reinvested In Employer
Securities
Under Code §404(k)(2)(A), an ESOP sponsor
may allow participants and their beneficiaries to
elect to reinvest applicable ESOP dividends in qualified employer securities through their accounts in
the ESOP without causing the employer to lose the
dividend deduction. An ESOP sponsor that offers
such an election must allow participants to elect:
• Either (i) payment of dividends in cash or (ii)
payment to the ESOP and distribution in cash
(not later than 90 days after the close of the
plan year in which the dividends are paid by the
corporation); or
• Payment of dividends to the ESOP for reinvestment in employer securities.
Notice 2002-2, 2002-1 C.B. 285, Q&A-2.
An ESOP may offer participants a choice
among the two cash payment options and the reinvestment option, and may provide that one of the
options will be the default election for participants
who fail to submit their dividend elections.
Dividends that are paid or reinvested as provided in Code section 404(k)(2)(A)(iii) are not treated
as annual additions under Code section 415(c), elective deferrals under Code section 402(g), elective
contributions under Code section 401(k), or employee contributions under Code section 401(m).
Notice 2002-2, Q&A-6.Dividends that are reinvested in qualifying employer securities at a participant’s election must be nonforfeitable. Code §404(k)
(4)(B) and (k)(7).This is without regard to whether
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the participant is vested in the stock for which the
dividend is paid. An ESOP also may comply with
the vesting requirement by offering an election only
to vested participants. Notice 2002-2, Q&A-9. Participants must be provided a reasonable opportunity to make the election before the dividend is paid
or distributed, must have a reasonable opportunity
to change their dividend elections at least annually,
and if there is a change in plan terms governing the
manner in which the dividends are paid or distributed to participants, they must have a reasonable
opportunity to make elections under the new plan
terms before the date on which the first dividend
subject to the new plan terms is paid or distributed.
Notice 2002-2, Q&A-3.
Dividends Applied To Loan Repayments
Under a leveraged ESOP, dividends or distributions paid on employer securities held by the ESOP
may be used to make loan repayments, provided
employer securities with a fair market value of not
less than the amount of the dividends or distributions are allocated to participant accounts for the
year in which the dividends or distributions would
have been paid to the participants. Code §404(k)
(for C corporations); Code §4975(f)(7), as amended
(for S corporations). Prior to the enactment of the
American Jobs Creation Act of 2004, only C corporations could use dividends paid with respect to
allocated shares to repay ESOP acquisition loans.
The American Jobs Creation Act of 2004, Pub. L.
No. 108-357, extended this rule to S corporations
under Code §4975, effective as of January 1, 1998.
This deduction applies only to dividends or distributions paid on employer securities (whether or not
they are allocated to participant accounts) actually
acquired with the proceeds of the loan that is being
repaid. If an ESOP loan is refinanced, dividends or
distributions on shares acquired with the original
loan may be deducted or eligible for the qualification and prohibited transaction relief if they are
Qualified Plans | 33
used to pay the refinanced debt. Priv Ltr. Rul. 9847-005 (Aug. 11, 1998).
Other Dividend Issues
Under Code section 302, certain transactions
that take the form of a corporation’s redemption
of its own stock are treated as dividends under the
Code. For example, if the sole owner of a corporation causes the corporation to redeem some of his
shares, still leaving him as the sole owner, that is the
functional equivalent of a dividend and is treated as
such under Code section 302.
One court has ruled that such a redemption
can be treated as a dividend under Code §404(k).
In Boise Cascade Corp. v. U.S., 329 F.3d 751 (9th Cir.
2003), the company authorized the issuance of
convertible preferred stock to implement an ESOP.
The stock could only be issued to the trustee of the
plan’s trust; if it were issued to any other person, it
automatically converted into common stock. The
trustee purchased all the shares of preferred stock
from the company, financed with loans from institutional investors and from the company. When
an employee terminated employment, the company redeemed shares of preferred stock held by
the trust equal in value to the employee’s vested
account balance. In 1989, the company redeemed
approximately 507 shares of preferred stock from
the ESOP to provide it with cash to distribute to
terminating employees, in a manner that would be
deemed substantially equivalent to a dividend under Code section 302 if the ESOP (rather than the
individual participants) were treated as the owner
of the ESOP stock. In 1996, the company filed an
amended return for 1989, claiming a deduction under Code section 404(k) for the payments made to
the ESOP to redeem the 507 shares. The IRS disallowed the claim, and the company filed a refund
suit.
Affirming the district court, the Ninth Circuit
held that the redemption payments were deductible
dividends under Code section 404(k). The govern-
ment argued that Boise was not entitled to deduct
the payments because the plan participants, not the
trustee, were the actual owners of the stock, and
therefore, the payments should be treated as a redemption, rather than a dividend. The court found
that the district court correctly determined that
the trust was the actual owner of the stock when it
was redeemed, reasoning that the Code generally
equates ownership with taxation and that Code sections 402 and 501 treat a trust as a separate entity,
taxable on its earnings. The court also found that
the incidents of stock ownership were all held by
the trust.
The Ninth Circuit also determined that the lower court correctly concluded that the Boise deduction was not disallowed under Code section 162(k)
(which disallows deductions “for any amount paid
or incurred by a corporation in connection with
the reacquisition of its stock”) because the redemption payments made to terminating employees were
separate from the 1989 dividend payments. The
court explained that two separate transactions occurred: the stock redemption by the company and
subsequent distributions to the plan participants
by the trustee. The court noted that, although the
plan provided that redemption of the convertible
preferred stock was required on employment termination, distribution of the amount redeemed did
not automatically occur. The court further noted
that the redemption was not a prerequisite to the
trustee’s duty to make distributions under the terms
of the plan.
Notwithstanding the Boise Cascade decision, the
IRS continues to maintain that amounts paid to an
ESOP in redemption of stock held by an ESOP
that are then distributed to terminating employees
are not deductible under Code section 404(k). In
Rev. Rul. 2001-6, 2001-1 C.B. 491 the IRS held
that such amounts are not deductible under Code
§404(k) for three reasons:
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• Code section 162(k) bars the deduction of
such payments without regard to whether they
would otherwise be deductible under Code section 404(k);
• Treatment of redemption proceeds as applicable dividends under Code section 404(i) (repealed) would produce such anomalous results
that Code section 404(k) could not reasonably
be construed as encompassing such payments,
because it would allow employers to claim deductions for payments that do not represent
true economic costs and would vitiate important
rights and protections for recipients of ESOP
distributions, including the right to reduce taxes
by utilizing the return of basic provisions under
Code section 72, the right to make rollovers of
ESOP distributions received upon separation
from service, and the protection against involuntary cash-outs; and
• Claiming a deduction for such amounts would
constitute an “evasion of taxation” within the
meaning of Code section 404(k)(5)(A).
Although the Boise Cascade decision explicitly rejected the IRS position on Code section 162(k), it never
addressed the “anomalous results” or “evasion of
taxation” grounds for Rev. Rul. 2001-6 because
these arguments were not before the court. Therefore, an employer that relies on the Boise Cascade
decision to claim Code section 404(k) deductions
for amounts redeemed from an ESOP to facilitate
distributions will still have to content with the contrary IRS position stated in Rev. Rul. 2001-6 and
Notice 2002-2. 285.Also, the IRS publicly stated
that it would fight the court’s position outside of
the Ninth Circuit. Chief Counsel Notice 2004-38
(Oct. 1, 2004).
Moreover, on August 30, 2006, the IRS released
final regulations that cover two ESOP dividend deduction scenarios. First, it would not allow companies to deduct the cost of repurchasing shares distributed from the ESOP. It explains in detail that a
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corporation may not take a deduction of payments
in redemption of its stock held by an ESOP used
to make benefit distributions to participants or
beneficiaries. 71 Fed. Reg. 51,471 (Aug. 30, 2006).
Specifically, Treasury Regulation section 1.404(k)-3
is devoted exclusively to “disallowance of deduction for reacquisition payments.” The regulation
expressly states that dividend payments used to repurchase shares distributed from the ESOP do not
constitute “applicable dividends” under the statue
and that the treatment of such payments as applicable dividends constitutes an avoidance or evasion
of taxes (and therefore subject to disallowance).
Second, it states that deductions for qualifying dividends on ESOP shares much be taken at the parent
company level, not the subsidiary level (which impacts foreign parent corporations). This means that
a foreign corporation that sponsors a U.S. ESOP,
such a DaimlerChrysler, BP, and others, will have
to try to claim a deduction under the laws of their
own country, something few, if any, can currently
do. There appear to be very few U.S. subsidiaries
of foreign companies that sponsor ESOPs. Two recent cases have also rejected the rationale of Boise
Cascade and held that a dividend deduction is not
allowed where a corporation redeemed its common
stock to satisfy distributions to terminated employees who cash out of the company’s ESOP. General
Mills, Inc. v. U.S., 554 F.3d 727 (8th Cir. 2009) and
Nestle Purina Petcare Co. v. Comm’r. 594 F.3d 968 (8th
Cir. 2010), cert. denied, 131 S.Ct 86 (2010).
Code SECTION 401(a)(28) Diversifica­
tion • To provide an opportunity to diversify out
of the employer securities that are the ESOP’s primary investment, an ESOP must offer “qualified
participants” — those who are at least age 55 and
have at least 10 years of participation in the plan
— an opportunity to “diversify” their holdings of
employer securities to the extent acquired by the
ESOP after 1986. Code §401(a)(28)(B).The ESOP
must permit the qualified participants to direct the
Qualified Plans | 35
investment of a certain percentage of the employer
securities held in their ESOP accounts into other
investment options during the “qualified election
period,” which is the six-plan‑year period beginning
with or after the plan year in which the participant
attains age 55 (or, if later, beginning with the plan
year in which the participant completes 10 years of
plan participation). Code §401(a)(28)(B)(iii).
An ESOP may satisfy this diversification requirement in two ways. The plan may distribute
to a participant, in stock or cash, the portion of
the participant’s account subject to the diversification requirement within 90 days after the period
in which the diversification election may be made.
Code §401(a)(28)(B)(ii)(I).If the ESOP distributes
stock, the put option requirements apply and the
stock may be rolled over into an IRA. An IRA that
receives a rollover of ESOP stock retains the put
option if the stock is not readily tradable on an established market at the time of distribution. If the
ESOP distributes cash, the participant may roll the
cash over into an IRA or another qualified plan
that accepts rollovers. Code §402(c).Any portion of
a diversification distribution that is not rolled over
is subject to taxation, including the 10 percent early
distribution penalty under Code section 72(v).
Alternatively the ESOP must make available
to qualified participants at least three diversified
investment options (other than employer stock).
Code §401(a)(28)(B)(ii)(II). If the trustee prefers to
minimize its fiduciary liability for the investment
decisions made by participants in the selection of
one of these funds, the plan should be designed to
comply with ERISA §404(c) and DOL Regulation
§2550.404c-1.An option to transfer assets to a plan
that permits employee self‑direction of investments
(such as the employer’s 401(k) or profit-sharing plan)
satisfies the diversification requirement. H.R. Rep.
No. 99-841, at II-558 (1986), as reprinted in 1986
U.S.C.C.A.N. 4075, 4646.
The ESOP is required only to offer the distribution or investment options to qualified participants.
A participant does not have to accept the diversification opportunity and may choose to stay fully
invested in employer securities. IRS Notice 88-56,
Q&A-15, 1989-1 C.B. 540.
Calculation Of Diversification Portion
The portion of a qualified participant’s account
that is subject to the diversification election during
the qualified election period is equal to:
• 25 percent (for the first five years of the qualified
election period) of the total number of shares
of employer securities acquired by or contributed to the plan after 1986 that have ever been
allocated to the qualified participant’s account
on or before the most recent plan allocation
date; less
• The number of shares of employer securities
previously distributed, transferred or otherwise
diversified pursuant to a diversification election
made after 1986.
The resulting number of shares may be rounded to
the nearest whole number. In the sixth year of the
qualified election period, “50 percent” is substituted
for “25 percent” in determining the amount subject
to the diversification election. Notice 88-56, Q&A9. The diversification computation is based solely
on the number of shares allocated to the qualified
participant’s account. Other assets allocated to the
account are not included in the computation.
Code §401(a)(35) And ERISA §204(j)
Diversification
The Pension Protection Act of 2006 Pub. L.
No. 109-280.required defined contribution plans
that hold publicly traded employer stock to permit
participants and certain beneficiaries to direct that
the portion of their accounts invested in employer
stock be reinvested in other investment options.
Code §401(a)(35)(B); ERISA §204(j)(2). ESOPs that
hold employer stock that is not publicly traded generally are not subject to the new diversification re-
36 | The Practical Tax Lawyer
quirements. Code §401(a)(35)(E)(i); ERISA §204(j)
(5)(A). If an ESOP sponsor or a member of the
ESOP sponsor’s controlled group has issued a class
of stock that is publicly traded, that ESOP would
be subject to the new requirements even if it does
not hold publicly traded stock, unless the ESOP
is a stand-alone plan (meaning that it is not combined with any other defined contribution or defined benefit plan) and cannot hold contributions,
and earnings thereon, that are subject to the nondiscrimination tests applicable to employee elective deferrals, employee after-tax contributions and
employer matching contributions. Code §401(a)(35)
(E)(ii); ERISA §204(j)(5)(B). If it is subject to these
requirements, an ESOP must permit amounts that
are attributable to elective deferrals and employee
after-tax contributions that are invested in employer stock to be transferred to alternative investments
by participants or beneficiaries who are permitted
to exercise participant rights. Code §401(a)(35)(B);
ERISA §204(j)(2).With respect to non-elective employer contributions and employer matching contributions that are held in employer stock, each participant who has completed at least three years of
vesting service, a beneficiary of such a participant,
and a beneficiary of a deceased participant must be
permitted to transfer such amounts to other investment options under the plan. Code §401(a)(35)(C);
ERISA §204(j)(3).
The diversification investment options must
consist of at least three investment alternatives other than employer stock, each of which is diversified
and has materially different risk and return features
from the others. Code §401(a)(35)(D)(i); ERISA
§204(j)(4).Diversification opportunities must be provided at least quarterly and at least as frequently
as other investment changes are permitted under
the plan. Code §401(a)(35)(D)(ii)(II); ERISA §204(j)
(4)(B)(ii). These diversification provisions apply for
plan years beginning after December 31, 2006.
Pension Protection Act of 2006, P.L. 109-280, Section 901(c)(1).
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Fiduciary Duty Under ERISA
An ESOP and its fiduciaries are subject to the
general fiduciary rules of ERISA §404(a), although
the application of such rules to an ESOP can differ
from the application to other qualified plans. For
example, ERISA provides special exemptions for
ESOPs with respect to the investment diversification requirements and related rules.
Exclusive Purpose And Prudence Rules
Although an ESOP is subject to the “exclusive
purpose” and “prudence” requirements of ERISA
that apply to all qualified defined contribution plans
subject to ERISA, the application of these rules to
ESOP fiduciaries must take into account the special
attributes of an ESOP as a plan “designed to invest
primarily in qualifying employer securities.” Code
§4975(e)(7)(A) and ERISA §407(d)(6).Under ERISA
section 404(a)(1), ESOP fiduciaries are responsible
for acquiring employer stock for the benefit of participants in a manner that demonstrates compliance with the “exclusive purpose” and “prudence”
rules under ERISA. The fiduciaries’ responsibility
is not to maximize retirement benefits through investments in assets other than employer stock, but
to maximize the benefits that may be achieved by
investing ESOP assets primarily in employer stock.
ERISA §407(d)(6)(A).
Qualified plans are prohibited from investing
in employer securities that are not “qualifying employer securities” and ERISA generally limits plan
investments in qualifying employer securities to 10
percent of plan assets. ERISA §407(a)(1) and (2).
However, the 10 percent limit does not apply to investments in qualifying employer securities (or qualifying employer real property) by an eligible individual account plan (EIAP). ERISA §407(b).EIAPs
include profit-sharing, stock bonus, thrift and savings plans, ESOPs, and certain money purchase
plans that were invested primarily in qualifying
employer securities on September 2, 1974 (the date
ERISA was enacted).Under these rules, an EIAP
Qualified Plans | 37
(including an ESOP) may invest 100 percent of its
assets in qualifying employer securities (or qualifying employer real property). ERISA §404(a)(2).To
the extent that an ESOP invests in assets other than
qualifying employer securities or real property, the
diversification requirements of ERISA §404(a)(1)
(C) apply.
Directed Trustee
Like other defined contribution plans, an ESOP
is required to have a trustee or custodian that manages or controls plan assets. ERISA §403(a).In many
cases, the trustee is a “directed trustee” that conducts transactions according to instructions from a
named fiduciary of the plan, such as the plan sponsor or a committee appointed by the plan sponsor.
A plan trustee by definition always will have some
fiduciary responsibility under ERISA because of its
control over plan assets. However, in most cases the
fiduciary responsibilities of a directed trustee are
narrower than the fiduciary responsibilities generally held by a discretionary trustee.
There are special issues, particularly with respect to directions that relate to employer securities,
which ESOP sponsors (as well as sponsors of other
types of plans that invest in employer stock) need
to consider as they appoint or monitor fiduciaries.
DOL Field Assistance Bulletin 2004-03 (December 17, 2004).Despite a directed trustee’s limited
fiduciary responsibilities, the trustee is required to
perform its duties prudently and solely in the interest of plan participants and beneficiaries. Given
that an ESOP is designed to invest primarily in employer securities, the directed trustee must monitor
company operations and investigate transactions
and developments as they occur and carry out directions only if they are consistent with the ESOP
terms and do not conflict with ERISA.
Special considerations arise when an ESOP has
a directed trustee and a tender offer is made to purchase the employer securities held by the ESOP. The
ESOP may allow participants to direct the trustee
whether or not to tender employer stock allocated
to their accounts. ERISA §403(a)(1) provides that a
trustee may carry out the directions of named fiduciaries, including participants, if the directions are
proper, made in accordance with plan provisions
and not contrary to ERISA (for which there is little
guidance). However, if a direction would result in a
breach of a fiduciary duty, the trustee may be liable
for any loss as a result of following the direction
unless it seeks court instructions. See, e.g., DOL Regulation §2509.75-5, Q&A-FR-10. In Gen. Couns.
Mem. 39,870, the IRS Chief Counsel advised that
an ESOP provision that allowed the trustee to consider non-financial employment-related factors in
tender offer situations, such as the continuing job
security of participants, violates the exclusive benefit rule of Code §401(a)(2). The GCM noted that
the DOL had concluded that this provision also violated the exclusive benefit rule of ERISA §404(a),
but indicated that the IRS has independent authority to construe the disputed provision and impose
the separate sanction of plan disqualification. Rev.
Rul. 69-494, 1969-2 C.B. 88.
According to Treasury Department and DOL
guidance, decisions relating to tender offers must
be based on the economic best interest of an employee benefit plan that holds employer securities,
recognizing that the plan’s purpose is to provide
retirement income. Joint Department of Labor/
Department of Treasury Statement of Pension
Investments, 16 Pens. & Benefits Rep. (BNA) 215
(Jan. 31, 1989).Prudence also requires fiduciaries to
make investment decisions, including tender offer
decisions, based on the facts and circumstances applicable to a particular plan. Therefore, an ESOP
trustee — particularly one that is directed by plan
sponsor personnel who may be most concerned
with keeping their jobs — must evaluate a tender
offer based on all of its merits and disadvantages
and weigh its fiduciary duties and the best interests
of the plan participants against the directions imparted by another named fiduciary.
38 | The Practical Tax Lawyer
Employer Stock Litigation
The National Center for Employee Ownership
(NCEO) has tracked litigation on these issues for its
various publications and, using this data, has created a 36-page categorized listing of all the cases,
except for a few on tangential issues. The report is
summarized in this article. See http://www.nceo.
org/main/pub.php/id/258. Listed in the report
are the case citations entered by the category of decisions in both ESOPs and 401(k) plans. If a case
had multiple issues decided, the decision on that issue is listed in a number of categories. Based on this
listing, the NCEO report provides a basic statistical
summary of key issues, albeit for some issues, the
decisions are too varied and nuanced to make such
simple analysis possible.
According to the NCEO report, employee stock
ownership plans (ESOPs) are mostly in closely held
companies, almost never require or even allow employee investments (they are funded by the company), and increasingly hold 100 percent of the shares,
often as a result of buying out an owner. Many of
these owners set up the plans not just for tax purposes, but also out of a commitment to employees
and community. What is most striking is that over
20 years, there have been only 141 ESOP cases in
closely held companies (plus 35 in public companies), not counting a handful not included in the
report because they deal with issues tangential to
current plans. The history makes it very clear that
companies that hire qualified professionals, follow
good plan practices, and are not using the ESOP to
extract money from the company for the benefit of
a few people (often by stretching the law), are very
unlikely to be sued, much less lose in court. The
table below summarizes the ESOPs the NCEO
has reported on. It provides a quick summary of
what issues come up most often and how they are
resolved. Because many cases had decisions made
by one or more courts on more than a single issue,
the total number of decisions is much greater than
the total number of cases filed (175). Where a com-
Fall 2011
pany has been sued on similar issues by different
plaintiffs, the NCEO counted that as one case.
Most of the decisions reported here were at the
pleading stages. Relatively few cases actually ended
up being decided at trial, as opposed to settled out
of court. Many others are still in process. Because
there are so many cross-cutting issues in these cases,
it is often not practical to give a simple statistical
summary of what ultimately was decided in each
case. In those instances where there are clear cut issues, however, in column three of the table, NCEO
reports the number of cases coming to one decision
or another (such as the presumption of prudence
of holding company stock or standing for former
participants). In summarizing decisions, NCEO ignored lower court rulings when an appeals court
ruled on the same subject, whether to accept or reverse. The one important exception is where a case
was remanded to a lower court and the lower court
reached a conclusion on a mater of law of some
significance.
By contrast, company stock in 401(k) plans is almost exclusively in plans sponsored by public companies, most often is an option for employee investments (and sometimes a match as well), and almost
never represents more than about 10 percent of the
total stock ownership. Most often, it is in the plan
because it is beneficial to the company to finance
the plan this way more than because of a deep
philosophical commitment to the concept. In the
NCEO view, concentrating stock in a 401(k) plan is
usually a dubious choice. In fact, most closely held
ESOP companies have both an ESOP and a separate diversified retirement plan.
The lessons for 401(k) plans are more mixed
than for ESOPs. If a plan mandates that employer
stock either be a match and/or investment options,
there is a good chance that even if the stock falls
sharply, the fiduciaries not lose in court (but may
end up settling outside of court). If it does not, the
chances are about 50-50. NCEO found that in 25
of the 37 cases tracked, courts largely followed the
Qualified Plans | 39
so-called Moench doctrine that presumes holding
employer stock in a plan is prudent. The doctrine
says that fiduciaries of a plan with company stock
are presumed to have made prudent choices unless they knew or had reason to know the company
was in dire straits. The presumption was developed
for ESOPs, however, and is granted less for 401(k)
plans, especially where the plan does not mandate
employer stock as an option. In addition, four cases
were dismissed because the plan mandated investment in company stock. In these cases, the court
did not have to apply the Moench presumption because the mandate was enough. These cases were
dismissed on the theory that just offering a choice
of investment was sufficient defense, but four were
allowed to proceed. Thirteen courts concluded that
fiduciaries could be required to disclose information
that was not yet public about company stock to plan
participants; 16 said they would not necessarily be
required to do so (a few of these decisions were not
just yes or no). Two-thirds of the courts have affirmed standing for former participants, while eight
have not. Class certification issues have reached a
variety of conclusions that are difficult to categorize simply. NCEO found 31 published settlements,
although there are likely many more that may not
be published. The typical settlements per employee
have been small (averaging about $1,000), although
some plans have also had to make changes in how
they operate. What is no doubt more impressive (but
not reported on Web sites by the various firms handling these cases) are the legal fees, which by now
have likely reached hundreds of millions of dollars.
While about 30 companies have succeeded in having the lawsuits dismissed at one stage or another,
many other cases are still slowly making their way
through the courts, so it may be years, and more
hundreds of millions of dollars in legal fees, before
we have conclusive guidance on these issues.
40 | The Practical Tax Lawyer
Fall 2011
NCEO Summary of ESOP Decisions 1990-2010
Issues
Number
of
Cases
Claims Against Providers
7
Deferral of Gains on Sale to ESOP
2
Disclosure to Participants
16
Distribution
21
Dividends
10
Employment Rights and Plan Eligibility
Issues
3
ESOPs as Takeover Defense
3
Executive Compensation
4
Indemnification
5
Lenders as Fiduciaries
2
Management of Plan Assets Other than
Stock Drop Cases
21
Management of Plan Assets, Stock Drop
Cases
18
Parties in Interest Definition
1
Securities Law Issues Other than Disclosure
2
Settlements
10
Standing
28
State Law Claims
14
Valuation
17
What Was Decided
6 of 7 allowed claims to proceed under
state law
Most cases on deductibility of
distributions as a 404(k) dividend. Almost
always concluding they are not.
Presumption of prudence almost
invariably upheld, but with occasional
reservations
Where the issue was whether former
employees retained standing, generally
died with employees
Qualified Plans | 41
Voting, Tendering Rights, and ESOP
Governance Rights
7
Who Is a Fiduciary?
29
Total Private Company ESOP Cases, 19902010
141
Total Public Company ESOP Cases, 19902010
34
The almost 300 decisions analyzed by NCEO are listed, categorized, and (for ESOP cases) very briefly
described in a new 40-page NCEO publication titled ESOP and 401(k) Plan Employer Stock Litigation Review:
1990-2010. Details are at http://www.nceo.org/main/pub.php/id/258.
Fiduciary Changes In Procedures To Limit
Risk Exposure
The employer stock litigation summarized in
the NCEO report has caused employer stock fiduciaries to pay more attention to their risk exposure
and make changes to reduce the risks associated
with acquiring and holding employer stock. For
example, many plans have been amended to remove the fiduciary exposure of the employer and
its board of directors by establishing plan committees and allocating to those committees in plan provisions the duty to administer the plans and select
investment options. In doing so, many employers
do not include the employer’s CEO or CFO on the
committee.
In addition, many employers have made a genuine effort to understand their fiduciary duties. This
has been accomplished through fiduciary training,
regular meetings and/or reviews of investments
and other plan issues, having fully documented delegations of regular responsibilities to the employer’s
staff, preparation of committee charters detailing
functions and responsibilities and carefully documenting the decision-making process on a contemporaneous basis. More attention is being paid to the
adequacy of employer indemnification arrangements and fiduciary insurance for plan fiduciaries,
as employers discover that the cost of defending a
fiduciary breach claim can exceed the potentially
liability associated with the claim.
As a further measure to reduce fiduciary exposure, some plan sponsors have turned to more
careful drafting of plan documents in an attempt
to reduce drafting errors and inconsistencies among
various plan documents. For example, the plan and
the trust agreement provisions relating to employer
stock issues must be consistent. The document focus even extends to summary plan descriptions and
releases provided to certain employees upon their
termination of employment.
Employer Stock Contribution To Defined
Benefit Plan
With so many corporate defined benefit plans
being in a funding shortfall position (that needs to
be reconciled by 2013) because of low interest rates
and overall market volatility at a time when preservation of corporate cash is vitally important, plan
sponsors are looking at many alternative solutions.
Some companies think that they have a solution
by contributing their own employer stock to their
defined benefit plan(s) in lieu of cash, particularly
if they believe that the market is undervaluing their
shares. This gives both the employer and the plan
an opportunity to benefit by the return that is generated by the market and employer stock recovery,
if all goes well.
42 | The Practical Tax Lawyer
There are a number of legal considerations to
be dealt with before this solution can be implemented, however. Even after these are resolved, there are
still pitfalls to be dealt with in terms of risk to the
plan if the stock market drops and the company’s
stock along with it, especially if the company goes
bankrupt and the stock becomes worthless.
Key among the legal hurdles are the 10 percent
limit on employer stock holdings of a defined benefit pension plan ERISA section 407(a).and a Supreme Court holding that an employer’s contribution of unencumbered property to defined benefit
plan is a prohibited transaction if such contribution
is made to satisfy the minimum funding obligation
of the employer. Commissioner v. Keystone Consolidated
Industries, 508 U.S. 152 (1993). In particular, ERISA
section 407(a) provides that, at the time a defined
benefit plan acquires employer stock, the fair market value of that stock cannot exceed 10 percent
of the fair market value of aggregate plan assets.
Further, section 4975(c)(1)(A) of the Code prohibits
any direct or indirect sale or exchange of property
between a plan and a disqualified person. Where a
contribution of property is made to satisfy an obligation such as the minimum funding obligations
of the employer under Section 412 of the Code,
the contribution of property is considered a “sale
or exchange.” Thus, the contribution of employer
stock must result in compliance with the 10 percent requirement and must not be made to satisfy
the minimum funding obligation of the employer.
Rather, the contribution must be for funding beyond the minimum required for a given plan year.
Other issues for implementation include review
of the trust agreement(s) for the plan(s) to assure
that holding employer stock is permissible and
amending the trust agreement(s) where necessary.
Careful review of the investment policy statement
will also need to be done and any necessary revisions made.
Plan governance should also be reviewed. It
may be advisable to remove the corporation’s board
Fall 2011
of directors from the investment policy decision
making process and allocate this to the plan committee. The decision to hold, sell, vote and tender
the employer stock may either be vested in the plan
committee or an independent fiduciary under the
plan governance provisions.
Federal securities laws should also be considered,
including insider trading restrictions, SEC ownership filings and resales by the plan of registered
shares of employer stock.
Fiduciary concerns must also be addressed. For
example, the prudence of holding or selling employer stock requires adequate diversification of the
total plan portfolio and the asset class and ongoing monitoring of appropriateness and allocation.
If the plan committee has the hold, sell, vote and
tender discretion, insider trading concerns and fiduciary conflict of interest (corporate versus participant interests) must be addressed.
If, on the other hand, the independent fiduciary is
given this discretion, the plan committee’s fiduciary
and some federal securities law issues will be minimized. The plan committee must monitor the independent fiduciary and take action if appropriate.
Finally, there are valuation considerations for
a contribution of employer stock. The corporate
tax deduction is limited to fair market value on the
date of the contribution, and the valuation for the
federal income tax deduction, the actuarial funded
status and the required minimum contribution may
be determined by market price or appraised value
(with the possibility of a discount to market price
for a “block discount” or for unregistered stock).
Rev. Rul. 73-583, 1973-2 CB 146. It should be
noted that employer stock may be the corporation’s
common stock, a convertible preferred stock or corporate bonds so long as immediately following the
acquisition of such bonds:
• No more than 25 percent of the aggregate
amount of the bonds issued in such issue and
outstanding at the time of acquisition is held by
the plan; and
Qualified Plans | 43
• At least 50 percent of the aggregate amount of
the bonds are held by persons independent of
the corporation.
ERISA §407(d)(5), Code §409(l)(3).
Conclusion • An ESOP is a unique form of
qualified defined contribution retirement plan. It
offers valuable retirement benefits and an equity in-
terest in the company to a broad base of employees
while providing corporate finance alternatives and/
or fulfilling other objectives. ESOPs present many
complexities with respect to plan design and operational compliance, and those counseling employers
that are considering establishing ESOPs, as well as
those that have implemented them, must take special care to ensure that they consider all the special
ESOP requirements under the Code and ERISA.
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